Saturday, September 20, 2008

Updates on Financial Meltdown


There is a lot of blame to go around for what is happening.   I found out from my reading that the SEC exempted 5 broker dealers (Merrill, Goldman, Morgan Stanley, Bear Stearns, and Lehman) from SEC leverage limits in 2004.  
To recap, let us look at the government's role in all that (notwithstanding the fact that borrowers and lenders are just as much to blame).   It is just another example of unrelated changes in government policy can cascade into financial disasters:
  1. The Federal Reserve in the mid 1990's until recently - abandons all pretense price stability, continues to recklessly expand the money supply.   The result was a weak U.S. dollar and artificially low interest rates.  This encouraged financial institutions and hedge funds to significantly leverage their balance sheets to goose up returns.   If we assume short term debt is at 3%, we lever 24-1 into a trade that makes 5%, our return on invested capital is 53% for the year.   Trades with small returns highly levered in a low interest rate environment create massive returns on capital.  However, small losses wipe out capital - which eventually happened.
  2. Mark-to-market accounting - accelerated this, distorting equity in these firms in upswings (thus allowing firms to take on more risk) and pushing the insolvency in downswings.  That, coupled with the fact that a lot of these assets have no real liquid market for determining fair market value.
  3. Capital requirements by the Fed under BASEL II used backward looking risk models that provided a feedback loop.   Using data from the last 20 years, essentially an extended bull market distorts the effects of low-probability, model changing events.   These risk models helped exacerbate the Mexican Peso crisis .   A risk model that is looks at the "fat tail" events and is more principal based would probably be wiser.
  4. Congress' enforcement of the Community Reinvestment Act under the Clinton administration (I wrote about this earlier, but the best source on this is from the City Journal, which is more thorough) essentially compelled lenders to provide loans to uncreditworthy people.   
  5. The tax system - with the mortgage interest deduction and property tax deduction is a government subsidy to home ownership that doesn't help.
  6. Freddie Mac and Fannie May were political entities that were told by their congressional masters to push more home ownership for people who shouldn't.
That's the short list .. 

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